Caution On Bond Markets
The change in US fiscal policy has translated into a more rapid-than-expected rise in US rates. We have significantly raised our target for the 10-year German bond to 0.75% and our 12-month target for the US Treasury bond to 2.75%. Returns on government bonds will be weak, below inflation levels.
Flows out of bonds into risky assets
Interest rates started to rise last summer due to a combination of factors: the return of inflation to positive territory (largely due to rising oil prices), moderate wage increases in the US, UK and Germany, countries with full employment, a generally improved trend in economic growth, a change in policy mix towards a more reflationary policy at a time when monetary policies are at the end of their cycle, and the start of a normalization of monetary policy, above all in the US.
These factors will continue to play in 2017, hence our forecast of more hikes to come. Returns on fixed-income investments will thus be low. And yet, over the past 10 years, flows towards bond markets have been colossal. Due to these unfavourable prospects, they started a reversal trend during the second half of 2016.
Good prospects for equities
Bond outflows are moving into equities. People are starting to talk again of this “great rotation” in favour of risky assets. A slightly more inflationary environment favours stock markets, as long as the rise in interest rates remains moderate (our scenario). Equity markets will benefit from a rise in corporate profits, above all in Europe and Japan, strengthened by the fall in the euro and yen vs. the dollar.
Moreover, the valuation levels of these two markets remain reasonable, particularly relative to the US market which is now expensive, following several years of outperformance.
These two fundamental arguments (rise in profits and attractive valuations) are durable, but we must not forget that volatility is not dead. Momentum is currently favourable to stock markets and it will continue. But later in the year, the risk factors could translate into reality.
These risks concern primarily the US where we will be closely following the first decisions taken by the Trump administration, particularly the issues of international trade (protectionist risk).
Moreover, as the Fed has started to tighten its monetary policy, the markets might worry again slightly later in the year. In China, the authorities are facing a dual challenge: currency weakness due to substantial capital outflows and the risk of an overheating in the real estate sector.
Finally the political agenda in Europe is packed for 2017: elections in the Netherlands in March, presidential elections in France in May and the general elections in Germany in the autumn. These events are widely known and partly explain the lag in the European stock markets. Moreover, the worst is never certain, far from it.
Overall, 2017 should be a good year for risky assets. However, do not lower your guard, because volatility may return at any time!